================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED JUNE 30, 2007
COMMISSION FILE NUMBER 000-21129
AWARE, INC.
-----------
(Exact Name of Registrant as Specified in Its Charter)
MASSACHUSETTS 04-2911026
------------- ----------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
-------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
(781) 276-4000
--------------
(Registrant's Telephone Number, Including Area Code)
Indicate by check whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
--- ---
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large Accelerated Filer Accelerated Filer X Non-Accelerated Filer
--- --- ---
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). YES NO X
--- ---
Indicate the number of shares outstanding of the issuer's common stock as of
July 27, 2007:
CLASS NUMBER OF SHARES OUTSTANDING
----- ----------------------------
Common Stock, par value $0.01 per share 23,738,143 shares
================================================================================
AWARE, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2007
TABLE OF CONTENTS
Page
----
PART I FINANCIAL INFORMATION
Item 1. Unaudited Consolidated Financial Statements
Consolidated Balance Sheets as of
June 30, 2007 and December 31, 2006........................ 3
Consolidated Statements of Operations for the
Three and Six Months Ended June 30, 2007
and June 30, 2006.......................................... 4
Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2007
and June 30, 2006.......................................... 5
Notes to Consolidated Financial Statements................. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................ 10
Item 3. Quantitative and Qualitative Disclosures about
Market Risk................................................ 15
Item 4. Controls and Procedures.................................... 16
PART II OTHER INFORMATION
Item 1. Legal Proceedings.......................................... 16
Item 1A. Risk Factors............................................... 16
Item 4. Submission of Matters to a Vote of Security Holders........ 25
Item 6. Exhibits .................................................. 26
Signatures................................................. 26
2
PART I. FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
JUNE 30, DECEMBER 31,
2007 2006
-------- --------
ASSETS
Current assets:
Cash and cash equivalents ............................................... $ 7,798 $ 8,571
Short-term investments .................................................. 31,390 29,263
Accounts receivable, net ................................................ 4,866 4,738
Inventories ............................................................. 1,156 819
Prepaid expenses and other current assets ............................... 448 867
-------- --------
Total current assets .............................................. 45,658 44,258
-------- --------
Property and equipment, net .................................................. 8,076 8,123
Investments .................................................................. - 1,968
Other assets, net ............................................................ 203 237
-------- --------
Total assets ...................................................... $ 53,937 $ 54,586
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ........................................................ $ 814 $ 692
Accrued expenses ........................................................ 106 153
Accrued compensation .................................................... 1,112 1,043
Accrued professional .................................................... 204 198
Deferred revenue ........................................................ 274 800
-------- --------
Total current liabilities ....................................... 2,510 2,886
-------- --------
Long-term deferred revenue ................................................... 330 330
Stockholders' equity:
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
none outstanding ................................................ - -
Common stock, $.01 par value; 70,000,000 shares authorized; issued
and outstanding, 23,738,143 as of June 30, 2007 and 23,642,753 as
of December 31, 2006 ............................................ 237 236
Additional paid-in capital ............................................. 82,715 81,923
Accumulated deficit .................................................... (31,855) (30,789)
-------- --------
Total stockholders' equity ...................................... 51,097 51,370
-------- --------
Total liabilities and stockholders' equity ...................... $ 53,937 $ 54,586
======== ========
The accompanying notes are an integral part of the consolidated financial statements.
3
AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2007 2006 2007 2006
-------- -------- -------- --------
Revenue:
Product sales .................... $ 3,771 $ 1,519 $ 7,236 $ 3,237
Contract revenue ................. 1,575 2,241 3,409 5,934
Royalties ........................ 1,083 1,030 1,584 1,754
-------- -------- -------- --------
Total revenue ................... 6,429 4,790 12,229 10,925
Costs and expenses:
Cost of product sales ............ 1,690 176 2,186 328
Cost of contract revenue ......... 1,410 1,151 2,762 2,397
Research and development ......... 2,867 3,129 5,655 5,919
Selling and marketing ............ 999 920 1,872 1,734
General and administrative ....... 927 1,066 1,811 2,070
-------- -------- -------- --------
Total costs and expenses ........ 7,893 6,442 14,286 12,448
Loss from operations ................. (1,464) (1,652) (2,057) (1,523)
Interest income ...................... 503 459 1,008 852
-------- -------- -------- --------
Loss before provision for income taxes (961) (1,193) (1,049) (671)
Provision for income taxes ........... 7 17 17 17
-------- -------- -------- --------
Net loss ............................. ($ 968) ($ 1,210) ($ 1,066) ($ 688)
======== ======== ======== ========
Net loss per share - basic ........... ($ 0.04) ($ 0.05) ($ 0.05) ($ 0.03)
Net loss per share - diluted ......... ($ 0.04) ($ 0.05) ($ 0.05) ($ 0.03)
Weighted average shares - basic ...... 23,715 23,430 23,687 23,371
Weighted average shares - diluted .... 23,715 23,430 23,687 23,371
The accompanying notes are an integral part of the consolidated financial statements.
4
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
----------------------
2007 2006
-------- --------
Cash flows from operating activities:
Net loss ..................................................... ($ 1,066) ($ 688)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization ............................... 426 322
Stock based compensation .................................... 487 1,242
Increase (decrease) from changes in assets and liabilities:
Accounts receivable .................................... (128) (245)
Inventories ............................................ (337) (463)
Prepaid expenses ....................................... 419 376
Accounts payable ....................................... 122 (209)
Accrued expenses ....................................... 28 161
Deferred revenue ....................................... (526) 280
-------- --------
Net cash provided by (used in) operating activities . (575) 776
-------- --------
Cash flows from investing activities:
Purchases of property and equipment ......................... (345) (232)
Sales of investments ........................................ 10,255 11,557
Purchases of investments .................................... (10,414) (7,446)
-------- --------
Net cash provided by (used in) investing activities . (504) 3,879
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock ..................... 306 640
-------- --------
Net cash provided by financing activities ........... 306 640
-------- --------
Increase (decrease) in cash and cash equivalents ................ (773) 5,295
Cash and cash equivalents, beginning of period .................. 8,571 13,068
-------- --------
Cash and cash equivalents, end of period ........................ $ 7,798 $ 18,363
======== ========
The accompanying notes are an integral part of the consolidated financial statements.
5
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
A) BASIS OF PRESENTATION
The accompanying unaudited consolidated balance sheet, statements of
operations, and statements of cash flows reflect all adjustments
(consisting only of normal recurring items) which are, in the opinion of
management, necessary for a fair presentation of financial position at
June 30, 2007, and of operations and cash flows for the interim periods
ended June 30, 2007 and 2006. Certain reclassifications have been made
to the prior year financial statements to conform to the current year
presentation.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with the instructions for Form 10-Q and therefore
do not include all information and footnotes necessary for a complete
presentation of our financial position, results of operations and cash
flows, in conformity with generally accepted accounting principles. We
filed audited financial statements which included all information and
footnotes necessary for such presentation for the three years ended
December 31, 2006 in conjunction with our 2006 Annual Report on Form
10-K.
The results of operations for the interim period ended June 30, 2007 are
not necessarily indicative of the results to be expected for the year.
B) INVENTORY
Inventories are stated at the lower of cost or market with cost being
determined by the first-in, first-out ("FIFO") method. Inventory
reserves are established for estimated excess and obsolete inventory.
JUNE 30, DECEMBER 31,
2007 2006
--------- ---------
Raw materials..................... $ 1,155 $ 819
Finished goods..................... 1 -
--------- ---------
Total ........................ $ 1,156 $ 819
========= =========
C) COMPUTATION OF EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income or loss by
the weighted average number of common shares outstanding. Diluted
earnings per share is computed by dividing net income or loss by the
weighted average number of common shares outstanding plus additional
common shares that would have been outstanding if dilutive potential
common shares had been issued. For the purposes of this calculation,
stock options are considered common stock equivalents in periods in
which they have a dilutive effect. Stock options that are anti-dilutive
are excluded from the calculation.
6
Net income or loss per share is calculated as follows (in thousands,
except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2007 2006 2007 2006
-------- -------- -------- --------
Net loss ................................... ($ 968) ($ 1,210) ($ 1,066) ($ 688)
Weighted average common shares outstanding . 23,715 23,430 23,687 23,371
Additional dilutive common stock equivalents - - - -
-------- -------- -------- --------
Diluted shares outstanding ................. 23,715 23,430 23,687 23,371
======== ======== ======== ========
Net loss per share - basic and diluted ..... ($ 0.04) ($ 0.05) ($ 0.05) ($ 0.03)
For the three month period ended June 30, 2007 and 2006 potential common
stock equivalents of 1,546,096 and 1,645,384, respectively, were not
included in the per share calculation for diluted EPS, because we had a
net loss and the effect of their inclusion would be anti-dilutive. For
the six month period ended June 30, 2007 and 2006 potential common stock
equivalents of 1,517,117 and 1,600,805, respectively, were not included
in the per share calculation for diluted EPS, because we had net losses
and the effect of their inclusion would be anti-dilutive. For the three
month periods ended June 30, 2007 and 2006, options to purchase
2,285,575 and 2,271,427 shares of common stock, respectively, were
outstanding, but were not included in the computation of diluted EPS
because the options' exercise prices were greater than the average
market price of the common stock and thus would be anti-dilutive. For
the six month periods ended June 30, 2007 and 2006, options to purchase
2,399,575 and 2,346,427 shares of common stock, respectively, were
outstanding, but were not included in the computation of diluted EPS
because the options' exercise prices were greater than the average
market price of the common stock and thus would be anti-dilutive.
D) STOCK-BASED COMPENSATION
The following table presents stock-based employee compensation expenses
included in the Company's unaudited consolidated statements of
operations (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------- -----------------
2007 2006 2007 2006
------ ------ ------ ------
Cost of product sales .......... $ 2 $ 5 $ 4 $ 8
Cost of contract revenue ....... 43 21 79 85
Research and development ....... 99 396 184 545
Selling and marketing .......... 25 110 46 178
General and administrative ..... 83 213 174 426
------ ------ ------ ------
Stock-based compensation expense $ 252 $ 745 $ 487 $1,242
====== ====== ====== ======
7
The Company estimates the fair value of stock options using the
Black-Scholes valuation model. This valuation model takes into account
the exercise price of the award, as well as a variety of significant
assumptions. These assumptions used to estimate the fair value of stock
options include the expected term, the expected volatility of the
Company's stock over the expected term, the risk-free interest rate over
the expected term, and the Company's expected annual dividend yield. The
Company believes that the valuation technique and the approach utilized
to develop the underlying assumptions are appropriate in calculating the
fair values of the Company's stock options granted in the six months
ended June 30, 2007. Estimates of fair value are not intended to predict
actual future events or the value ultimately realized by persons who
receive equity awards.
E) BUSINESS SEGMENTS
The Company organizes itself as one segment and conducts its operations
in the United States.
The Company sells its products and technology to domestic and
international customers. Revenues were generated from the following
geographic regions (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2007 2006 2007 2006
------- ------- ------- -------
United States....... $ 3,566 $ 2,098 $ 7,615 $ 6,574
Germany ............ 1,735 2,236 2,740 3,502
Rest of World....... 1,128 456 1,874 849
------- ------- ------- -------
$ 6,429 $ 4,790 $12,229 $10,925
======= ======= ======= =======
F) INCOME TAXES
We adopted the provisions of Financial Standards Accounting Board
Interpretation No. 48 Accounting for Uncertainty in Income Taxes ("FIN
48") an interpretation of FASB Statement No. 109 ("SFAS 109") on January
1, 2007. As a result of the implementation of FIN 48, we recognized no
material adjustment in the liability for unrecognized income tax
benefits. At the adoption date of January 1, 2007 and also at June 30,
2007, we had no unrecognized tax benefits.
We recognize interest and penalties related to uncertain tax positions
in income tax expense. As of June 30, 2007, we had no accrued interest
or penalties related to uncertain tax positions.
The tax years 2003 through 2006 remain open to examination by the major
taxing jurisdictions to which we are subject.
As of December 31, 2006, we had federal net operating loss and research
and experimentation credit carryforwards of approximately $49.9 million
and $11.4 million respectively, which may be available to offset future
federal income tax liabilities and expire at various dates from 2007
through 2026. In addition, at December 31, 2006, we had approximately
$8.3 million and $5.8 million of state net operating losses and state
8
research and development and investment tax carryforwards, respectively,
which expire at various dates from 2007 through 2021.
Utilization of net operating loss and research and development credit
carryforwards may be subject to a substantial annual limitation due to
ownership change limitations that have occurred previously or that could
occur in the future provided by Section 382 of the Internal Revenue Code
of 1986, as well as similar state provisions. These ownership changes
may limit the amount of net operating loss and research and development
credit carryforwards that can be utilized annually to offset future
taxable income and tax, respectively. The Company has not currently
completed a study to assess whether a change of control has occurred.
Until a study is completed and any limitation known, no amounts are
being presented as an uncertain tax position under FIN 48.
G) RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued Statement No. 157, "Fair Value
Measurements" ("SFAS 157"). The Statement provides guidance for using
fair value to measure assets and liabilities. This Statement references
fair value as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market
participants in the market in which the reporting entity transacts. The
Statement applies whenever other standards require (or permit) assets or
liabilities to be measured at fair value. The Statement does not expand
the use of fair value in any new circumstances. It is effective for
financial statements issued for fiscal years beginning after November
15, 2007, and interim periods within those fiscal years. The adoption of
SFAS 157 is not expected to have a material impact on our financial
position, results of operations or cash flows.
In February 2007, the FASB issued Statement of Financial Accounting
Standards No. 159, "The Fair Value Option for Financial Assets and
Financial Liabilities, including an amendment of FASB Statements No.
115" ("SFAS 159"). SFAS 159 permits entities to choose, at specified
election dates, to measure eligible items at fair value (the "fair value
option"). A business entity shall report unrealized gains and losses on
items for which the fair value option has been elected in earnings at
each subsequent reporting period. This accounting standard is effective
as of the beginning of an entity's first fiscal year that begins after
November 15, 2007. The effect, if any, of adopting SFAS 159 on our
financial position and results of operations has not been finalized.
9
ITEM 2:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
SOME OF THE INFORMATION IN THIS FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS
THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE
STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "MAY," "WILL," "EXPECT,"
"ANTICIPATE," "BELIEVE," "ESTIMATE," "CONTINUE" AND SIMILAR WORDS. YOU SHOULD
READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR
FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR
FINANCIAL CONDITION; OR (3) STATE OTHER "FORWARD-LOOKING" INFORMATION. HOWEVER,
WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED
IN THIS FORM 10-Q, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-Q, PROVIDE
EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING
STATEMENTS. YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS
DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-Q COULD MATERIALLY
AND ADVERSELY AFFECT OUR BUSINESS.
RESULTS OF OPERATIONS
PRODUCT SALES. Product sales consist of revenue from the sale of
hardware and software products. Hardware products include ADSL test and
development systems, modules, and modems. Software products consist of standard
off-the-shelf software products for biometric, medical imaging and digital
imaging applications, as well as DSL test and diagnostics software.
Product sales increased 148% from $1.5 million in the second quarter of 2006 to
$3.8 million in the current year quarter. As a percentage of total revenue,
product sales increased from 32% in the second quarter of 2006 to 58% in the
current year quarter. The dollar increase was primarily due to a $1.9 million
increase in revenue from the sale of hardware, and a $0.4 million increase in
the sale of software.
For the six months ended June 30, 2007, product sales increased 124% from $3.2
million in 2006 to $7.2 million in 2007. As a percentage of total revenue,
product sales increased from 30% in the first six months of 2006 to 59% in the
corresponding period of 2007. The dollar increase was primarily due to a $3.1
million increase in revenue from the sale of hardware, and a $0.9 million
increase in revenue from the sale of software.
CONTRACT REVENUE. Contract revenue consists of patent, license and
engineering service fees that we receive under agreements relating to Aware's
patents, Aware's DSL technology and Aware's DSL test and diagnostic technology.
Contract revenue decreased 30% from $2.2 million in the second quarter of 2006
to $1.6 million in the current year quarter. As a percentage of total revenue,
contract revenue decreased from 47% in the second quarter of 2006 to 25% in the
current year quarter. The dollar decrease was due to $0.5 million recognized
from the transfer of certain technology licenses as a result of the
10
acquisition of a customer's business in the second quarter of 2006, of which
there was no similar transaction in the second quarter of 2007. In addition,
there was a decrease of $0.2 million associated with the delivery of licensed
technology and engineering services.
For the six months ended June 30, 2007, contract revenue decreased 43% from $5.9
million in 2006 to $3.4 million in 2007. As a percentage of total revenue,
contract revenue decreased from 54% in the first six months of 2006 to 28% in
the corresponding period of 2007. The dollar decrease was primarily due to $2.5
million recognized from the transfer of certain technology licenses as a result
of the acquisition of a customer's business in the first six months of 2006, of
which there was no similar transaction in the first six months of 2007.
While we believe that the transition to ADSL2+ and VDSL2 technology increases
the value proposition of our technology, some existing and prospective DSL
chipset licensees have continued to be reluctant to begin new development
projects given a difficult and uncertain environment in the semiconductor and
telecommunications industries, and intense ADSL chipset competition and falling
chipset prices. During the last several years, customers and potential customers
cautiously evaluated new chipset projects or delayed or cancelled projects in
the face of such conditions.
ROYALTIES. Royalties consist of royalty payments that we receive under
licensing agreements. We receive royalties from customers for the right to use
our patents and technology in their chipsets or solutions.
Royalties increased 5% from $1.0 million in the second quarter of 2006 to $1.1
million in the current year quarter. As a percentage of total revenue, royalties
decreased from 21% in the second quarter of 2006 to 17% in the current year
quarter. The dollar increase in royalties was primarily due to a $0.1 million
net increase in DSL royalties as a result of increases in ADSL royalties offset
by decreases in VDSL royalties.
For the six months ended June 30, 2007, royalties decreased 10% from $1.8
million in 2006 to $1.6 million in 2007. As a percentage of total revenue,
royalties decreased from 16% in the first six months of 2006 to 13% in the
corresponding period of 2007. The dollar decrease in royalties was due to a net
$34,000 decrease in DSL royalties, resulting from a decrease in VDSL royalties,
and a $137,000 decrease in biometrics and medical imaging royalties.
Our royalty revenue comes predominantly from ADSL chipset sales by Ikanos
Communications, Inc. ("Ikanos"), and Infineon Technologies AG ("Infineon").
Despite steady growth of worldwide ADSL subscribers over the last several years,
the availability of ADSL chipsets from a number of suppliers and intense
competition among those suppliers has caused chipset prices to steadily decline.
We are uncertain how the transition to ADSL2+ and VDSL2 will impact our
customers in the near term, how quickly sales of our customers' chipsets will
increase and whether such increases will contribute meaningful royalties to us.
We have experienced fluctuations from period to period in our VDSL2 royalties
due to the purchasing patterns for our customers' chipsets and cannot guarantee
this will be a meaningful revenue stream for us. Infineon recently announced its
intention to acquire Texas Instruments' DSL CPE product line. We are uncertain
how this acquisition may affect our future royalty revenues.
COST OF PRODUCT SALES. Since the cost of software product sales is
minimal, cost of product sales consists primarily of the cost of hardware
product sales. Cost of product sales increased 858% from $0.2 million in the
second quarter of 2006 to $1.7 million in the current year quarter. As a
percentage of product sales, cost of product sales increased from 12% in the
11
second quarter of 2006 to 45% in the current year quarter. The percentage and
dollar increases were primarily due to increases in cost of product sales
associated with new hardware products, which resulted in a lower product gross
margin as a percent of product sales. However, product gross margin dollars
increased primarily due to an increase in test and diagnostic hardware and
software sales, and to a lesser extent an increase in other software sales.
For the six months ended June 30, 2007, cost of product sales increased 565%
from $0.3 million in 2006 to $2.2 million in 2007. As a percentage of product
sales, cost of product sales increased from 10% in the first six months of 2006
to 30% in the corresponding period of 2007. The percentage and dollar increases
were primarily due to increases in cost of product sales associated with new
hardware products, which resulted in a lower product gross margin as a percent
of product sales. However, product gross margin dollars increased primarily due
to an increase in test and diagnostic hardware and software sales, and to a
lesser extent an increase in other software sales.
COST OF CONTRACT REVENUE. Cost of contract revenue consists primarily of
compensation costs for engineers and expenses for consultants, technology
licensing fees, recruiting, supplies, equipment, depreciation and facilities
associated with customer development projects. Our total engineering costs are
allocated between cost of contract revenue and research and development expense.
In a given period, the allocation of engineering costs between cost of contract
revenue and research and development is a function of the level of effort
expended on each.
Cost of contract revenue increased 23% from $1.2 million in the second quarter
of 2006 to $1.4 million in the current year quarter. Cost of contract revenue as
a percentage of contract revenue increased from 51% in the second quarter of
2006 to 90% in the current year quarter. The percentage and dollar increase in
cost of contract revenue was primarily due to higher compensation costs
principally related to an increase in the level of effort expended on our
customer projects during the current quarter.
For the six months ended June 30, 2007, cost of contract revenue increased 15%
from $2.4 million in the first six months of 2006 to $2.8 million in the
corresponding period of 2007. Cost of contract revenue as a percentage of
contract revenue increased from 40% in the first six months of 2006 to 81% in
the corresponding period of 2007. The percentage and dollar increase in cost of
contract revenue was primarily due to higher compensation costs principally
related to an increase in the level of effort expended on our customer projects
during the first six months of 2007.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense
consists primarily of compensation costs for engineers and expenses for
consultants, recruiting, supplies, equipment, depreciation and facilities
related to engineering projects to improve our broadband intellectual property
offerings, as well as our software and hardware product technology.
Research and development expenses decreased from $3.1 million in the second
quarter of 2006 to $2.9 million in the current year quarter. As a percentage of
total revenue, research and development expense decreased from 65% in the second
quarter of 2006 to 44% in the current year quarter. For the three month period,
the dollar decrease was mainly attributable to lower stock-based compensation
expense of $297,000 that was partially offset by higher salary and other
compensation costs of $51,000.
12
Research and development expenses decreased from $5.9 million in the first six
months of 2006 to $5.7 million in the first six months of 2007. As a percentage
of total revenue, research and development expense decreased from 54% in the
first six months of 2006 to 46% in the corresponding period of 2007. For the six
month period, the dollar decrease was mainly attributable to lower stock-based
compensation expense of $361,000 and lower consulting and outside services fees
of $182,000 that was partially offset by higher salary and other compensation
costs of $75,000, higher professional services fees of $150,000 and higher
software maintenance fees of $31,000.
Our research and development spending was principally focused on improving our
ADSL, ADSL2 and ADSL2plus StratiPHY2+(TM) technology and chips, developing and
improving our VDSL2 StratiPHY3 technology and chips, developing bonded ADSL and
VDSL technology and chips, developing analog front-end technology for DSL
solutions, developing test and diagnostics hardware and software and developing
imaging and biometrics software.
SELLING AND MARKETING EXPENSE. Selling and marketing expense consists
primarily of compensation costs for sales and marketing personnel, travel,
advertising and promotion, recruiting, and facilities expense. Sales and
marketing expense increased 9% in the current quarter compared with the
corresponding quarter of 2006, and was $0.9 million in the second quarter of
2006 and $1.0 million in the current year quarter. As a percentage of total
revenue, sales and marketing expense decreased from 19% in the second quarter of
2006 to 15% in the current year quarter. For the three month period, the dollar
increase was mainly attributable to increases in salary and other compensation
costs of $124,000 and consulting fees of $40,000 that was partially offset by
lower stock-based compensation expense of $85,000.
For the six months ended June 30, 2007, sales and marketing expenses increased
8%, from $1.7 million in 2006 to $1.9 million in 2007. As a percentage of total
revenue, sales and marketing expenses decreased from 16% in the first six months
of 2006 to 15% in the corresponding period of 2007. The dollar increase in sales
and marketing expenses was mainly attributable to increases in salary and other
compensation costs of $225,000 and consulting fees of $52,000 that was partially
offset by lower stock-based compensation expense of $132,000.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense
consists primarily of compensation costs for administrative personnel, facility
costs, bad debt, audit, legal, stock exchange and insurance expenses. General
and administrative expenses decreased 14% from $1.1 million in the second
quarter of 2006 to $0.9 million in the current year quarter. As a percentage of
total revenue, general and administrative expense decreased from 23% in the
second quarter of 2006 to 14% in the current year quarter. For the three month
period, the dollar decrease was mainly attributable to lower stock-based
compensation expense of $130,000 and investor relations expenses of $27,000.
For the six months ended June 30, 2007, general and administrative expenses
decreased 13% from $2.1 million in 2006 to $1.8 million in 2007. As a percentage
of total revenue, general and administrative expenses decreased from 19% in the
first six months of 2006 to 15% in the corresponding period of 2007. The dollar
decrease was mainly attributable to lower stock-based compensation expense of
$252,000 and recruiting fees of $65,000.
INTEREST INCOME. Interest income increased 10% from $459,000 in the
second quarter of 2006 to $503,000 in the current year quarter. For the six
months ended June 30, 2007, interest
13
income increased 18%, from $852,000 in 2006 to $1,008,000 in 2007. For the three
and six month periods, the dollar increase was primarily due to higher interest
rates earned on our cash and investment balances.
INCOME TAXES. We made no provision for income taxes in the first six
months of 2006 and 2007 due to net losses incurred and the uncertainty of the
timing of profitability in future periods, except for $17,000 of state excise
tax paid in both 2006 and 2007. In 2002, we determined that due to our
continuing operating losses as well as the uncertainty of the timing of
profitability in future periods, we should fully reserve our deferred tax
assets. As of June 30, 2007, our deferred tax assets continue to be fully
reserved. We will continue to evaluate, on a quarterly basis, the positive and
negative evidence affecting the realizability of our deferred tax assets.
We adopted the provisions of Financial Standards Accounting Board Interpretation
No. 48 Accounting for Uncertainty in Income Taxes ("FIN 48") an interpretation
of FASB Statement No. 109 ("SFAS 109") on January 1, 2007. As a result of the
implementation of FIN 48, we recognized no material adjustment in the liability
for unrecognized income tax benefits. At the adoption date of January 1, 2007
and also at June 30, 2007, we had no unrecognized tax benefits.
We recognize interest and penalties related to uncertain tax positions in income
tax expense. As of June 30, 2007, we had no accrued interest or penalties
related to uncertain tax positions.
The tax years 2003 through 2006 remain open to examination by the major taxing
jurisdictions to which we are subject.
As of December 31, 2006, we had federal net operating loss and research and
experimentation credit carryforwards of approximately $49.9 million and $11.4
million respectively, which may be available to offset future federal income tax
liabilities and expire at various dates from 2007 through 2026. In addition, at
December 31, 2006, we had approximately $8.3 million and $5.8 million of state
net operating losses and state research and development and investment tax
carryforwards, respectively, which expire at various dates from 2007 through
2021.
Utilization of net operating loss and research and development credit
carryforwards may be subject to a substantial annual limitation due to ownership
change limitations that have occurred previously or that could occur in the
future provided by Section 382 of the Internal Revenue Code of 1986, as well as
similar state provisions. These ownership changes may limit the amount of net
operating loss and research and development credit carryforwards that can be
utilized annually to offset future taxable income and tax, respectively. The
Company has not currently completed a study to assess whether a change of
control has occurred. Until a study is completed and any limitation known, no
amounts are being presented as an uncertain tax position under FIN 48.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2007, we had cash, cash equivalents, and short-term investments of
$39.2 million, which represents a decrease of $0.6 million from December 31,
2006. The decrease was primarily due to $0.6 million of cash used in operations
and $0.3 million of capital expenditures. The decrease was partially offset by
$0.3 million of proceeds from the exercise of employee stock options.
14
Cash used in operations in the first six months of 2007 was from the net loss of
$1.1 million adjusted for non-cash items related to depreciation and
amortization of $0.4 million, and stock based compensation expense of $0.5
million and working capital requirements of $0.4 million. Capital spending was
primarily related to the purchase of computer hardware and software, and
laboratory equipment used principally in engineering activities.
While we can not assure you that we will not require additional financing, or
that such financing will be available to us, we believe that our cash, cash
equivalents and short-term investments will be sufficient to fund our operations
for at least the next twelve months.
RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued Statement No. 157, "Fair Value Measurements"
("SFAS 157"). The Statement provides guidance for using fair value to measure
assets and liabilities. This Statement references fair value as the price that
would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants in the market in which the reporting
entity transacts. The Statement applies whenever other standards require (or
permit) assets or liabilities to be measured at fair value. The Statement does
not expand the use of fair value in any new circumstances. It is effective for
financial statements issued for fiscal years beginning after November 15, 2007,
and interim periods within those fiscal years. The adoption of SFAS 157 is not
expected to have a material impact on our financial position, results of
operations or cash flows.
In February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities,
including an amendment of FASB Statements No. 115" ("SFAS 159"). SFAS 159
permits entities to choose, at specified election dates, to measure eligible
items at fair value (the "fair value option"). A business entity shall report
unrealized gains and losses on items for which the fair value option has been
elected in earnings at each subsequent reporting period. This accounting
standard is effective as of the beginning of an entity's first fiscal year that
begins after November 15, 2007. The effect, if any, of adopting SFAS 159 on our
financial position and results of operations has not been finalized.
ITEM 3:
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk relates primarily to our investment portfolio, and
the effect that changes in interest rates would have on that portfolio. Our
investment portfolio has included:
o Cash and cash equivalents, which consist of financial
instruments with original maturities of three months or less;
and
o Investments, which consist of financial instruments that meet
the high quality standards specified in our investment policy.
This policy dictates that all instruments mature in three years
or less, and limits the amount of credit exposure to any one
issue, issuer, and type of instrument.
We do not use derivative financial instruments for speculative or trading
purposes. As of June 30, 2007, we had $39.2 million in cash, cash equivalents
and short-term investments that matured in twelve months or less. Due to the
short duration of these financial instruments, we do not
15
expect that an increase in interest rates would result in any material loss to
our investment portfolio.
ITEM 4:
CONTROLS AND PROCEDURES
Our management, including our chief executive officer and chief financial
officer, has evaluated our disclosure controls and procedures as of the end of
the quarterly period covered by this Form 10-Q and has concluded that our
disclosure controls and procedures are effective. They also concluded that there
were no changes in our internal control over financial reporting that occurred
during the quarterly period covered by this Form 10-Q that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
PART II. OTHER INFORMATION
ITEM 1:
LEGAL PROCEEDINGS
From time to time we are involved in litigation incidental to the conduct of our
business. We are not party to any lawsuit or proceeding that, in our opinion, is
likely to seriously harm our business.
ITEM 1A:
RISK FACTORS
RISK FACTORS
OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY
Our quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter-to-quarter. Because our revenue components
fluctuate and are difficult to predict, it is difficult for us to accurately
forecast revenues and profitability. When appropriate, we recognize contract
revenues ratably over the period during which we expect to deliver technology
and provide engineering services. While this means that contract revenues from
certain current agreements are generally predictable, changes can be introduced
by a reevaluation of the length of the development period, or by the termination
of a contract. The initial estimate of this period is subject to revision as the
product being developed under a contract nears completion, and a revision may
result in an increase or decrease to the quarterly revenue for that contract. In
addition, accurate prediction of revenues from new contracts or licensees is
difficult because contract negotiation is a lengthy process, frequently spanning
a year or more, and the fiscal period in which a new license agreement will be
entered into, if at all, and the financial terms of such an agreement are
difficult to predict. Contract revenues also include fees for engineering
services, which are dependent upon the varying level of assistance desired by
licensees and, therefore, the revenue from these services is also difficult to
predict.
It is also difficult for us to make accurate forecasts of royalty revenues.
Royalties are recognized in the quarter in which we receive a report from a
licensee regarding the shipment of licensed integrated circuits in the prior
quarter, and are dependent upon fluctuating sales volumes and/or prices of chips
containing our technology, all of which are beyond our ability to control or
assess in advance.
16
It is also difficult for us to make accurate forecasts of product revenues.
Product revenues consist of sales of test and diagnostics hardware as well as
biometrics, medical imaging and test and diagnostics software. Sales of hardware
and software products fluctuate based upon demand by our customers which is
difficult to predict. Since our product revenues include the sales of hardware
products which typically have lower gross margins than our other sources of
revenue, profitability is difficult to predict.
Our business is subject to a variety of additional risks, which could materially
adversely affect quarterly and annual operating results, including:
o market acceptance of broadband technologies we supply by
semiconductor or equipment companies;
o the extent and timing of new license transactions with
semiconductor companies;
o changes in our and our licensees' development schedules and
levels of expenditure on research and development;
o the loss of a strategic relationship or termination of a project
by a licensee;
o equipment companies' acceptance of integrated circuits produced
by our licensees;
o the loss by a licensee of a strategic relationship with an
equipment company customer;
o announcements or introductions of new technologies or products
by us or our competitors;
o delays or problems in the introduction or performance of
enhancements or of future generations of our technology;
o failures or problems in our hardware or software products;
o price pressure in the biometrics or test and diagnostics markets
from our competitors;
o delays in the adoption of new industry standards or changes in
market perception of the value of new or existing standards;
o competitive pressures resulting in lower contract revenues or
royalty rates;
o competitive pressures resulting in lower software or hardware
product revenues;
o personnel changes, particularly those involving engineering and
technical personnel;
o costs associated with protecting our intellectual property;
o the potential that licensees could fail to make payments under
their current contracts;
o ADSL market-related issues, including lower ADSL chipset unit
demand brought on by excess channel inventory and lower average
selling prices for ADSL chipsets as a result of market
surpluses;
o VDSL market-related issues, including lower VDSL chipset unit
demand brought on by excess channel inventory and lower average
selling prices for VDSL chipsets as a result of market
surpluses;
o hardware manufacturing issues, including yield problems in our
hardware platforms, and inventory buildup and obsolescence;
o product gross margin may be affected by various factors
including, but not limited to, product mix, product life cycle,
and provision for excess and obsolete inventory.;
o significant fluctuations in demand for our hardware products;
o regulatory developments; and
o general economic trends and other factors.
As a result of these factors, we believe that period-to-period comparisons of
our revenue levels and operating results are not necessarily meaningful. You
should not rely on our quarterly revenue and operating results to predict our
future performance.
17
WE EXPERIENCED NET LOSSES
We had a net annual loss during 2001, 2002, 2003, 2004 and 2005 and the first
six months of 2007. We may experience losses in the future if:
o the semiconductor and telecommunications markets decline;
o our existing customers do not increase their revenues from sales
of chipsets with our technology;
o new or existing customers do not choose to license our
intellectual property for new chipset products; or
o new or existing customers do not choose to use our software or
hardware products.
WE HAVE A UNIQUE BUSINESS MODEL
The success of our DSL licensing products depends upon our ability to license
our technology to semiconductor and equipment companies, and our customers'
willingness and ability to sell products that incorporate our technology so that
we may receive significant royalties that are consistent with our plans and
expectations.
We face numerous risks in successfully obtaining suitable licensees on terms
consistent with our business model, including, among others:
o we must typically undergo a lengthy and expensive process of
building a relationship with a potential licensee before there
is any assurance of a license agreement with such party;
o we must persuade semiconductor and equipment manufacturers with
significant resources to rely on us for critical technology on
an ongoing basis rather than trying to develop similar
technology internally;
o we must persuade potential licensees to bear development costs
associated with our technology applications and to make the
necessary investment to successfully manufacture chipsets and
products using our technology; and
o we must successfully transfer technical know-how to licensees.
Moreover, the success of our business model also depends on the receipt of
royalties from licensees. Royalties from our licensees are often based on the
selling prices of our licensees' chipsets and products, over which we have
little or no control. We also have little or no control over our licensees'
promotional and marketing efforts. They are not prohibited from competing
against us.
Our business could be seriously harmed if:
o we cannot obtain suitable licensees;
o our licensees fail to achieve significant sales of chipsets or
products incorporating our technology; or
o we otherwise fail to implement our business strategy
successfully.
18
THERE HAS BEEN AND MAY CONTINUE TO BE A CYCLICAL DEMAND FOR DSL CHIPSETS, AND
THERE IS INTENSE COMPETITION FOR DSL CHIPSETS, WHICH HAS CAUSED OUR ROYALTY
REVENUE TO DECLINE
The royalties we receive are influenced by many of the risks faced by the DSL
market in general, including cyclical demand which may result in reduced average
selling prices ("ASPs") for DSL chipsets during periods of surplus. In the past,
the DSL industry has experienced an oversupply of DSL chipsets, central office
or customer premises equipment. Excessive inventory levels led to soft chipset
demand, which in turn led to declining ASPs. ASPs have also been under pressure
because of intense competition in the DSL chipset marketplace. As a result of
the soft demand and declining ASPs for ADSL chipsets, our royalty revenue has
decreased substantially from the levels we achieved in 2000. Price decreases for
ADSL or VDSL chipsets, and the corresponding decreases in per unit royalties
received by us, can be sudden and dramatic. Pricing pressures may continue
during the third quarter of 2007 and beyond. Our royalty revenue may decline
over the long term.
WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES
There are a relatively limited number of semiconductor and equipment companies
to which we can license our broadband technology in a manner consistent with our
business model. If we fail to maintain relationships with our current licensees
or fail to establish a sufficient number of new licensing relationships, our
business could be seriously harmed. In addition, our prospective customers may
use their superior size and bargaining power to demand license terms that are
unfavorable to us and prospective customers may not elect to license from us.
WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM A SMALL NUMBER OF CUSTOMERS
In 2004, 2005 and 2006, we derived 28%, 20% and 20%, respectively, of our total
revenue from ADI and 28%, 30%, and 26% respectively, of our total revenue from
Infineon. ADI and Infineon have developed many generations of ADSL chipsets
based upon our technology. On February 17, 2006 ADI sold its ADSL business
relating to Aware technology to Ikanos Communications, Inc. ("Ikanos") and
Ikanos replaced ADI as an Aware licensee. Our royalty revenue in the near term
is highly dependent upon the respective market share and pricing of Ikanos' and
Infineon's ADSL chipsets. The ADSL market has experienced significant price
erosion, which has adversely affected ADSL chipset revenues, which in turn has
adversely affected our royalty revenue. To the extent that Ikanos loses ADSL2+
market share or Infineon loses market share, is unable to gain market share, is
unable to transition its product to support new ADSL2, ADSL2+ and VDSL2
standards, or experiences further price erosion in its DSL chipsets, our royalty
revenue could decline.
OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES
Due to our business strategy, our success is dependent on our ability to
generate significant royalties from our licensing arrangements with
semiconductor manufacturers. Our ability to generate significant royalties is
materially affected by the willingness of equipment companies to purchase
integrated circuits that incorporate our technology from our licensees. There
are other competitive solutions available for equipment companies seeking to
offer broadband communications products. We face the risk that equipment
manufacturers will choose those
19
alternative solutions. Generally, our ability to influence equipment companies'
decisions whether to purchase integrated circuits that incorporate our
technology is limited.
We also face the risk that equipment companies that elect to use integrated
circuits that incorporate our technology into their products will not compete
successfully against other equipment companies. Many factors beyond our control
could influence the success or failure of a particular equipment company that
uses integrated circuits based on our technology, including:
o competition from other businesses in the same industry;
o market acceptance of its products;
o its engineering, sales and marketing, and management
capabilities;
o technical challenges of developing its products unrelated to our
technology; and
o its financial and other resources.
Even if equipment companies incorporate chipsets based on our intellectual
property into their products, their products may not achieve commercial
acceptance or result in significant royalties to us.
OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL DSL SERVICE IN VOLUME
The success of our DSL licensing business depends upon telephone companies
installing DSL service in significant volumes. Factors that affect the volume
deployment of DSL service include:
o the desire of telephone companies to install ADSL or VDSL
service, which is dependent on the development of a viable
business model for ADSL or VDSL service, including the
capability to market, sell, install and maintain the service;
o the pricing of ADSL or VDSL services by telephone companies;
o the success of internet protocol TV ("IPTV") or video-based
services as viable consumer service offerings;
o the transition by telephone companies to new ADSL technologies,
such as ADSL2, ADSL2+ and VDSL2;
o the quality of telephone companies' networks;
o deployment by phone companies of fiber-to-the-home or broadband
wireless services;
o government regulations; and
o the willingness of residential telephone customers to demand DSL
service in the face of competitive service offerings, such as
cable modems, fiber-based service or broadband wireless access.
If telephone companies do not install DSL service in significant volumes, or if
telephone companies install broadband service based on other technology such as
cable or fiber-to-the-home, our business will be seriously harmed.
OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION
Because we are a technology provider, our ability to protect our intellectual
property and to operate without infringing the intellectual property rights of
others is critical to our success. We regard our technology as proprietary, and
we have approximately 48 U.S. patents and 105 foreign patents and a number of
pending patent applications. We also rely on a combination of trade secrets,
copyright and trademark law and non-disclosure agreements to protect our
unpatented
20
intellectual property. Despite these precautions, it may be possible for a third
party to copy or otherwise obtain and use our technology without authorization.
As part of our licensing arrangements, we typically work closely with our
semiconductor and equipment manufacturer licensees, many of whom are also our
potential competitors, and provide them with proprietary know-how necessary for
their development of customized chipsets based on our ADSL technology. Although
our license agreements contain non-disclosure provisions and other terms
protecting our proprietary know-how and technology rights, it is possible that,
despite these precautions, some of our licensees might obtain from us
proprietary information that they could use to compete with us in the
marketplace. Although we intend to defend our intellectual property as
necessary, the steps we have taken may be inadequate to prevent
misappropriation.
In the future, we may choose to bring legal action to enforce our intellectual
property rights. Any such litigation could be costly and time-consuming for us,
even if we were to prevail. Moreover, even if we are successful in protecting
our proprietary information, our competitors may independently develop
technologies substantially equivalent or superior to our technology. The
misappropriation of our technology or the development of competitive technology
could seriously harm our business.
Our technology, software or products may infringe the intellectual property
rights of others. A large and increasing number of participants in the
telecommunications and compression industries have applied for or obtained
patents. Some of these patent holders have demonstrated a readiness to commence
litigation based on allegations of patent and other intellectual property
infringement. Third parties may assert patent, copyright and other intellectual
property rights to technologies that are important to our business. In the past,
we have received claims from other companies that our technology infringes their
patent rights. Intellectual property rights can be uncertain and can involve
complex legal and factual questions. We may infringe the proprietary rights of
others, which could result in significant liability for us. If we were found to
have infringed any third party's patents, we could be subject to substantial
damages and an injunction preventing us from conducting our business.
OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE
The semiconductor and telecommunications industries for high-speed network
access technologies, are characterized by rapid technological change, with new
generations of products being introduced regularly and with ongoing evolutionary
improvements. We expect to depend on our DSL technology for a substantial
portion of our revenue for the foreseeable future. Therefore, we face risks that
others could introduce competing technology that renders our DSL technology less
desirable or obsolete. Also, the announcement of new technologies could cause
our licensees or their customers to delay or defer entering into arrangements
for the use of our existing technology. Either of these events could seriously
harm our business. The biometrics industry is also subject to rapid
technological change and uncertainty.
We expect that our business will depend to a significant extent on our ability
to introduce enhancements and new generations of our DSL and biometrics
technology and products as well as new technologies and products that keep pace
with changes in the telecommunications and broadband industries and that achieve
rapid market acceptance. It is expected that the International Telecommunication
Union will be issuing a new standard for VDSL in the fall of 2008. We must
continually devote significant engineering resources to achieving technical
innovations and product developments. These developments are complex and require
long
21
development cycles. Moreover, we may have to make substantial investments in
technological innovations and product developments before we can determine their
commercial viability. We may lack sufficient financial resources to fund future
development. Also, our licensees may decide not to share certain research and
development costs with us. Revenue from technological innovations, even if
successfully developed, may not be sufficient to recoup the costs of
development.
One element of our business strategy is to assume the risks of technology
development failure while reducing such risks for our licensees and OEM
customers. In the past, we have spent significant amounts on development
projects that did not produce any marketable technologies or products, and we
cannot assure you that it will not occur again.
WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS
Our success as an intellectual property supplier depends on the willingness and
ability of semiconductor manufacturers to design, build and sell integrated
circuits based on our intellectual property. The semiconductor industry is
intensely competitive and has been characterized by price erosion, rapid
technological change, short product life cycles, cyclical market patterns and
increasing foreign and domestic competition.
As an intellectual property supplier to the semiconductor industry, we face
intense competition from internal development teams within potential
semiconductor customers. We must convince potential licensees to license from us
rather than develop technology internally. Furthermore, semiconductor customers,
who have licensed our intellectual property, may choose to abandon joint
development projects with us and develop chipsets themselves without using our
technology. In addition to competition from internal development teams, we
compete against other independent suppliers of intellectual property. We
anticipate intense competition from suppliers of intellectual property for ADSL.
The market for DSL chipsets is also intensely competitive. Our success within
the DSL industry requires that DSL equipment manufacturers buy chipsets from our
semiconductor licensees, and that telephone companies buy DSL equipment from
those equipment manufacturers. Our customers' chipsets compete with products
from other vendors of standards-based and DSL chipsets, including Broadcom,
Centillium, Conexant, Ikanos, Texas Instruments and ST Microelectronics.
Infineon, one of our larger customers, recently announced their intention to
acquire Texas Instruments' DSL CPE product line. We are uncertain as to how this
acquisition may affect us from a competitive standpoint.
ADSL and VDSL services offered over copper telephone networks also compete with
alternative broadband transmission technologies that use the telephone network
as well as other network architectures. Alternative technologies for the
telephone network include several types of symmetric high speed DSL, including
HDSL, SDSL and G.SHDSL. Alternative technologies that use other network
architectures to provide high-speed data service include cable modems using
cable networks, wireless solutions using wireless networks, and optical
solutions using fiber optics technology. These alternative broadband
transmission technologies may be more successful than ADSL or VDSL and we may
not be able to participate in the markets involving these alternative
technologies.
Many of our current and prospective DSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Broadcom,
Conexant, ST Microelectronics and Texas Instruments, have significantly greater
financial, technological, manufacturing, marketing
22
and personnel resources than we do. We may be unable to compete successfully,
and competitive pressures could seriously harm our business.
WE ARE DEPENDENT ON A SINGLE SOURCE CONTRACT MANUFACTURER FOR THE MANUFACTURE OF
OUR DSL HARDWARE PRODUCTS, THE LOSS OF WHICH WOULD HARM OUR BUSINESS
We currently depend on one contract manufacturer to manufacture our DSL hardware
products. If this company was to terminate its arrangement with us or fail to
provide the required capacity and quality on a timely basis, we would be unable
to manufacture our products until replacement contract manufacturing services
could be obtained. To qualify a new contract manufacturer, familiarize it with
our products, quality standards and other requirements, and commence production
is a costly and time-consuming process. We cannot assure you that we would be
able to establish alternative manufacturing relationships on acceptable terms.
Although we make reasonable efforts to ensure that our contract manufacturer
performs to our standards, our reliance on a single source limits our control
over quality assurance and delivery schedules. Defects in workmanship,
unacceptable yields, and manufacturing disruptions and difficulties may impair
our ability to manage inventory and cause delays in shipments and cancellation
of orders that may adversely affect our relationships with current and
prospective customers. As a result, our revenues and operations may be harmed.
OUR MANUFACTURING SYSTEMS MAY NOT BE ADEQUATE FOR OUR DSL TEST AND DIAGNOSTICS
HARDWARE PRODUCT OFFERINGS
Our current manufacturing systems adequately address hardware products we are
currently manufacturing in limited volumes. Our manufacturing systems have not
been extensively tested under anticipated, more complex hardware products or in
volumes higher than that of our current hardware products. If our manufacturing
systems are inadequate or have other problems, our revenues and operating
results may be harmed.
WE ARE DEPENDENT ON SINGLE SOURCE SUPPLIERS FOR COMPONENTS IN OUR DSL HARDWARE
PRODUCTS
We rely on single source suppliers for components and materials used in our DSL
Hardware products. Our dependence on single source suppliers involves several
risks, including limited control over pricing, availability, quality and
delivery schedules. Any delays in delivery of such components or shortages of
such components could cause delays in the shipment of our products, which could
significantly harm our business. Because of our reliance on these vendors, we
may also be subject to increases in component costs. These increases could
significantly harm our business. If any one or more of our single source
suppliers cease to provide us with sufficient quantities of our components in a
timely manner or on terms acceptable to us, we would have to seek alternative
sources of supply. We could incur delays while we locate and engage alternative
qualified suppliers and we might be unable to engage alternative suppliers on
favorable terms. We could incur substantial hardware and software redesign costs
if we are required to replace the components. Any such disruption or increased
expenses could harm our commercialization efforts and adversely affect our
ability to generate revenues.
23
BIOMETRICS BUSINESS RISKS
Our biometrics business is subject to a variety of additional risks, which could
materially adversely affect quarterly and annual operating results, including:
o market acceptance of our biometric technologies and products;
o changes in contracting practices of government or law
enforcement agencies;
o the failure of the biometrics market to experience continued
growth;
o announcements or introductions of new technologies or products
or our competitors;
o delays or problems in the introduction or performance of
enhancements or of future generations of our technology;
o failures or problems in our biometric software products;
o delays in the adoption of new industry biometric standards or
changes in market perception of the value of new or existing
standards;
o growth of proprietary biometric systems which do not conform to
industry standards;
o competitive pressures resulting in lower software product
revenues;
o personnel changes, particularly those involving engineering,
technical and sales and marketing personnel;
o costs associated with protecting our intellectual property;
o litigation by third parties for alleged infringement of their
proprietary rights;
o the potential that licensees could fail to make payments under
their current contracts;
o regulatory developments; and
o general economic trends and other factors.
WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS
We prepare our financial statements in accordance with generally accepted
accounting principles and certain critical accounting polices that are relevant
to our business. The application of these principles and policies requires us to
make significant judgments and estimates. In the event that judgments and
estimates we make are incorrect, we may have to change them, which could
materially affect our financial position and results of operations.
Moreover, accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years. The implementation of new standards requires us to interpret and apply
them appropriately. If our current interpretations or applications are later
found to be incorrect, our financial position and results of operations could be
materially affected.
OUR STOCK PRICE MAY BE EXTREMELY VOLATILE
Volatility in our stock price may negatively affect the price you may receive
for your shares of common stock and increases the risk that we could be the
subject of costly securities litigation. The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:
o quarterly fluctuations in our operating results;
o changes in future financial guidance that we may provide to
investors and public market analysts;
o changes in our relationships with our licensees;
24
o announcements of technological innovations or new products by
us, our licensees or our competitors;
o changes in DSL or biometrics market growth rates as well as
investor perceptions regarding the investment opportunity that
companies participating in the DSL or biometrics industry afford
them;
o changes in earnings estimates by public market analysts;
o key personnel losses;
o sales of our common stock; and
o developments or announcements with respect to industry
standards, patents or proprietary rights.
In addition, the equity markets have experienced volatility that has
particularly affected the market prices of equity securities of many high
technology companies and that often has been unrelated or disproportionate to
the operating performance of such companies. These broad market fluctuations may
adversely affect the market price of our common stock.
OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS
The extensive regulation of the telecommunications industry by federal, state
and foreign regulatory agencies, including the Federal Communications
Commission, and various state public utility and service commissions, could
affect us through the effects of such regulation on our licensees and their
customers. In addition, our business may also be affected by the imposition of
certain tariffs, duties and other import restrictions on components that our
customers obtain from non-domestic suppliers or by the imposition of export
restrictions on products sold internationally and incorporating our technology.
Changes in current or future laws or regulations, in the United States or
elsewhere, could seriously harm our business.
ITEM 4:
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 23, 2007, we held our Annual Meeting of Stockholders (the "Annual
Meeting"). Matters voted on and the results of those votes are set forth below:
(1) Each of John K. Kerr and Mark G. McGrath was elected to serve as
a Class II direcctor of the Company for a term expiring at the
annual meeting of stockholders of the Company in 2010 or a
special meeting in lieu thereof. Each of Frederick D. D'Alessio,
G. David Forney, Jr., Adrian F. Kruse, Edmund C. Reiter and
Michael A. Tzannes continued to serve as a director following
the Annual Meeting.
The votes cast to elect the Class II directors were:
Name For Abstain
John K. Kerr 16,048,621 395,664
Mark G. McGrath 16,048,771 395,514
25
ITEM 6:
EXHIBITS
(A) EXHIBITS
Exhibit 31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
--------------------
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
AWARE, INC.
Date: August 2, 2007 By: /s/ Michael A. Tzannes
-------------------------------------
Michael A. Tzannes, Chief Executive
Officer
Date: August 2, 2007 By: /s/ Keith E. Farris
-------------------------------------
Keith E. Farris, Chief Financial
Officer (Principal Financial and
Accounting Officer)
26